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Do all your stocks and mutual funds look alike?

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POSTED: August 22, 2007 5:03 a.m.

Like most people, you probably gravitate toward things that you’re familiar with and that you like. If you enjoy classical music, your shelves may be full of Beethoven and Ravel. If you love pasta, your cupboards may be bulging with spaghetti and ravioli. In most parts of your life, there’s nothing wrong with this type of devotion — but, if it’s carried over to your investment portfolio, you could run into problems.

Specifically, you don’t want to own too many of the same types of stocks or mutual funds — even if you like these investments and are generally pleased with their performance.

What’s wrong with "the more, the merrier" approach to investing? Simply put, it’s too risky. Suppose you own a bunch of stocks of companies that belong to the same industry, or to just a couple of related industries. If a particular set of economic or market forces hurt these industries, then your stocks are going to take a hit — and if most of your investment dollars are tied up in these holdings, your overall portfolio will take a hit, too.

You might think that you can avoid this problem of "over-concentration" by investing in mutual funds. After all, mutual funds may invest in dozens of different companies at any time, so you’re protected from any industry-specific downturns, aren’t you? Actually, it’s not quite that simple. There are many different types of mutual funds available on the market, and some of them do concentrate in a particular market segment, such as technology. And when something happens that affects these segments, such as the bursting of the technology "bubble" in 2001, these types of mutual funds will be negatively affected. If, in 2001, you owned just one technology-heavy fund, your overall portfolio probably wasn’t shaken up too much, but if you had several of these funds, you would definitely have felt some pangs of regret when you opened your investment statement.

Keep this in mind: Different investments may respond differently to the same market forces. To give just one example, a steep rise in interest rates may hurt the stocks of financial services companies, but have relatively little effect on pharmaceutical stocks. On the other hand, certain legal or regulatory changes can have a big impact on drug company stocks, but not cause a stir in the financial services industry. Consequently, if you spread your investment dollars among different types of stocks and mutual funds (as well as bonds, certificates of deposit and government securities), you’ll be less vulnerable to those forces — all beyond your control — that may affect one particular class of assets. Diversification does not guarantee a profit nor does it protect against loss.

And here’s one more reason to expand your investment horizons: You probably won’t be able to achieve all your financial goals if you only own one type of investment, such as growth stocks or growth-oriented mutual funds. Over time, you will have other considerations, such as the need for income, so you’ll need to address this in your portfolio.

These factors also affect the way you approach your 401(k) or other employer-sponsored retirement plan. You may have a dozen or more investment options in your plan, so don’t just stick with one or two of them.

In the investment world, you’ve got many choices — so take advantage of this freedom and flexibility. It can potentially pay off in the long run.

Evans is a financial advisor with Edward Jones in Richmond Hill.

 

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